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Margin Debt Can Do More Harm Than Good

Warren Buffett — one of the richest and most successful investors — invests according to his own rules.

His company, Berkshire Hathaway, has averaged an annual growth in book value of 19.1%. That compares favourably with the S&P 500, which has seen annual growth (with dividends) of 9.9%.

What are some of his rules?

For one, he doesn’t like to lose money…but who does?

Rule No.1: Never lose money. Rule No. 2: Don’t forget rule No. 1.

He is also a big believer in compound interest — reinvesting earnings and getting interest paid on that interest. In fact, he attributes much of his wealth to this:

My wealth has come from a combination of living in America, some lucky genes, and compound interest.

What’s more, to Buffett, price is different to value. He likes to take advantage of low-priced but high-valued acquisitions:

Price is what you pay. Value is what you get.

In his recent annual letter to shareholders, Buffett announced that his company is holding US$116 billion in cash and treasury bills.

With interest rates at record lows, this money is, as he put it, making ‘a pittance’.

And, as he admitted, it is a much higher amount than he would like to be holding. But, with stock markets at record highs, he is struggling to find opportunities.

Buffett notes:

In our search for new stand-alone businesses, the key qualities we seek are durable competitive strengths; able and high-grade management; good returns on the net tangible assets required to operate the business; opportunities for internal growth at attractive returns; and, finally, a sensible purchase price.

That last requirement proved a barrier to virtually all deals we reviewed in 2017, as prices for decent, but far from spectacular, businesses hit an all-time high. Indeed, price seemed almost irrelevant to an army of optimistic purchasers.

Don’t load on debt to buy stocks

When others are optimistic, he would rather hold large amounts of cash than buy into high-priced but low-value assets.

He is sticking to his simple guideline of: ‘The less the prudence with which others conduct their affairs, the greater the prudence with which we must conduct our own.

In other words, be fearful when others are greedy and greedy when others are fearful.

In fact, his recent letter also shared examples of instances when Berkshire Hathaway’s vision of long-term growth was blurred by high prices.

He shared the ‘gory details’ of four occurrences when his company’s shares got butchered.

Warren Buffett Shares 28-02-2018

Source: Berkshire Hathaway
[Click to enlarge]

As you can see, all four dips coincided with major market drops. That is, the 1973 oil crisis, the 1987 ‘Black Monday’, the dotcom bubble, and the Global Financial Crisis.

The table offers another great piece of advice: Don’t load on debt to buy stocks.

Buffett again:

This table offers the strongest argument I can muster against ever using borrowed money to own stocks. There is simply no telling how far stocks can fall in a short period. Even if your borrowings are small and your positions aren’t immediately threatened by the plunging market, your mind may well become rattled by scary headlines and breathless commentary. And an unsettled mind will not make good decisions.

In the next 53 years our shares (and others) will experience declines resembling those in the table. No one can tell you when these will happen. The light can at any time go from green to red without pausing at yellow.

A dangerous way in which investors have been doing this is through margin debt.

That’s where investors borrow money against their portfolio to buy more stocks. In a rising market, investors do this as a way to increase gains…

According to the Financial Industry Regulatory Authority, retail and institutional investors have now borrowed a record US$642 billion against their portfolios.

As you can see in the graph below, margin debt and stock markets move in sync.

Margin Debt and Stock Markets 28-02-2018

Source: Yardeni Research
[Click to enlarge]

Less margin debt means more opportunity

Margin debt is also an indicator of investor confidence…and boy are investors confident!

A rising market and the idea that things will stay the same are pushing investors to take on more risk. They are so bullish that they are willing to stake increasing amounts in a rising market.

And to do this, they are not taking money from other assets into stocks, but are instead using their current portfolio as an ATM.

Margin debt is also a big way in which brokers make money. From The Washington Post:

Lending against securities is a key profit center for brokerages, as firms charge interest on the money that is used and say they have found they better retain clients who take on the debt. These loans can also factor into brokers’ compensation, incentivizing many to extend money to clients regardless of whether they need it or not.

But, in the same way margin debt can push the market up, it can also speed it up on the way down…and magnify losses.

Yesterday I wrote about interest-only mortgages and the dangers of getting stuck with more debt than an asset is worth.

Margin debt is something similar.

You see, if the market takes a downturn, the value of the portfolio used as collateral falls.

If the portfolio falls enough that it does not cover debt, it is enough for the bank to ask for repayment. This means that brokers will start dumping the stock in the portfolio…which makes the selloff even worse.

Selling off in a down market could mean that, at the end of the day, clients are left with no portfolio…and in debt.

At a time when central bankers are starting to tighten interest rates, margin debt could make these selloffs even worse.

The new US Federal Reserve chair Jerome Powell is trying to keep markets calm by maintaining the status quo. But he may not be able to.

The US is nearing full employment, and inflation is starting to tick up.

Inflation has been coming in under the Fed’s expectations. Yet it could increase after the US tax boost, which could mean that central bankers start rising rates more than projected.

Just looking at Berkshire Hathaway, the company reported US$65 billion in profits, of which US$29 billion was ‘delivered’ to them through the recent US tax cut.

More money to spend could mean more inflation…

Investors may have to wake up to the fact that interest rates are going up…that volatility is back…and that things may not stay the same…

Which brings us to another of Buffett’s pearls of wisdom:

When major declines occur, however, they offer extraordinary opportunities to those who are not handicapped by debt.

And that is the time when holding large amounts of cash and no debt could come in handy.

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